The Bloomberg article refers to a paper which can be summarized as follows:

But it is much harder to explain why most active equity managers fail to keep up with the benchmark index, a shortcoming that implies these investment professionals are doing something that systematically leads to underperformance.

The answer, we believe, lies in the fact that the best performing stocks in a broad index perform much better than the other stocks in the index, most of which perform relatively badly. That means average index returns depend heavily on the relatively small set of winners.

Everyone who is actively investing in stocks knows how hard it is to actually find the “great stocks”. Looking back, it always looks so easy. Buying Coca Cola when it was cheap and local would have been clearly a no-brainer, buying Wal-Mart when Sam Walton went public also looks very obvious. Even Berkshire 25 years ago would have been an easy one. But those things only look easy with what we know now.

Few Value investors today for instance own Amazon, because “it never made money”. However it looks more and more that Amazon is what Wal-Mart was long ago, a dominating retailer with some long-lasting competitive advantages. In 10 or 20 years time the next generation of value investor might say: “Amazon was really easy back then in 2013/2015”. Only time will tell….

If we include the fact that for many investors, holding periods are relatively short, the problem even compounds. You have to own the right share at the right time. Even the best stocks have sometimes big draw downs and few people actually sit them out our even time them perfectly.

So stock picking is hard, no doubt. Many potential winners have almost always the problem that they are either very expensive or very risky, which both leads to potentially lower returns than the index if things don’t turn out to be as one hoped. So picking really good stocks is extremely hard and even if one owns the “good ones”, the outperformance manifests itself only over longer time periods. Very few managers are able to beat benchmarks year by year, and even some of those like Bill Miller got wiped out at some point in time.

There are of course investors you are successfully picking (and holding) winners. Combined with a concentrated portfolio this sometimes leads to spectacular results. However I do think that most of those guys do have special abilities which are not that easy to copy. It is a little bit like watching Christiano Ronaldo, Messi and Neymar playing football and saying: This is how to play football. In most cases this will obviously not work. “Learning from the best” is a good concept but not always directly applicable.

But maybe avoiding losers is easier ?

So let’s look at the other article. They look at the full set of return distributions for stocks and find quite interesting results:

39% of stocks had a negative lifetime total return (2 out of every 5 stocks are a money losing investment)
18.5% of stocks lost at least 75% of their value (Nearly 1 out of every 5 stocks is a really bad investment)
64% of stocks underperformed the Russell 3000 during their lifetime (Most stocks can’t keep up with a diversified index)
A small minority of stocks significantly outperformed their peers

Those numbers seem to even strengthen the first post that winners are a really small percentage of overall stocks. On the other hand we see that also the other, negative side of the distribution has a rally “fat tail”.

The percentage of big losers is almost equal to winners. Most astonishing for me however were the 40% of stocks with negative “lifetime performance”.. This is a lot if you assume that “on average” the stock market makes something between 6-8% p.a. long-term.

However in my opinion, avoiding losers is much easier than picking winners. For instance I guess that the negative lifetime returns have a lot to do with expensive IPOs of risky companies. So by consequently avoiding IPOs you might miss some winners but also you will in the long-term eliminate a much larger percentage of badly performing stocks.

Another well-known fact is that large acquisitions and or mergers often fail (2/3 of large acquisitions do not create value). So again, avoiding those companies will eliminate a lot more losers than winners.

From my personal experience, I would add a few other criteria with how one can identify potential long-term underperformers relatively easy:

I think one big mistake that many value investors make is that the make compromises when the price is “cheap” enough. Buying cheap businesses in structural declining industries for instance does “enhance” your chances to end up with a typical value trap.

Buying cheap businesses with questionable accounting or motives because they are cheap leads to the typical “Globo” or “Asian Bamboo” outcomes.

This is also one of the reasons why I stopped looking at “deep value” screeners like the “Magic Sixes” or “Net nets”. Yes, there might be potential winners but it even harder to select those as most of the really cheap stocks are “cheap for a reason”.

Story stocks

In the book “Think like a Freak”, the authors explain very nicely why telling a nice story can make people do something that they normally would not do. The same can be seen over and over in the stock market. How can you make investors buy a stock which they normally won’t touch ? It’s easy, tell a convincing story and after the first buyers come in, momentum might take the stock very far at least for some time. Some “stories” of the most recent times were:

– Industry 4.0.
– Chinese consumer
– Cloud / Big Data
– Fintech

Without having a statistical prove, I would claim that investing in such “stories” will produce even more losers than in the statistics shown above. There might be a occassional winner but in my experience it is much safer to stay away as far as possible from those kind of stocks.

Why don’t do more investors make sure not to invest into losers ?

I think there are wo main reasons why this approach is not that popular:

1) You end up mostly with pretty boring stocks. No great stories to tell your investors or fellow fund managers
2) Low beta and potential underperformance for longer stretches of time

Especially when you are in the mutual fund industry, one or two bad quarters will automatically create problems. So owning stuff which is “Not hot” might be good in the long run but bad for the short run. If you filter out all the aggressive, questionable or “hot” stocks, you usually end up with a selection of very boring, unsexy companies which more often than not have low betas as well. Low betas mean that if the stock market goes up strongly in a quarter you will underperform which again creates problems.

As I have written before, in order to execute such a strategy successfully, one has to create the right environment. A mutual fund with a large institutional ownership is maybe the worst structure as the money will leave quickly following even shorter stretches of underperformance. Permanent money, maybe even your own is often the best (and only) way to execute such long-term approaches. However it is pretty difficult to get permanent money as fund manager.

Interestingly the “low volatility anomaly” is relatively well-known but not that widely implemented. I guess that the “low vol” stocks are to a large extend stocks which would pass most of the filters above.

Summary:

Outperforming indices is really hard. However there is a very simple but rarely used strategy to shift the odds to the favour of stock pickers:

Instead of focusing on trying to pick winners, use real strong filters and avoid companies which are very likely to be long-term losers. In the long run, this will shift the probabilities to your advantage as a surprisingly large share of stocks have long-term negative returns.

Systematically avoiding the bad ones by selecting only rock-solid “non story” stocks at the right price is a strategy which due to the “Law of large numbers” will shift the odds to the long-term oriented investor who is patient enough to withstand occasional underperformance in hot markets.

Or to use an analogy from football: Before you think about the offense, make sure that the defense is in place.

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21 comments

I’m also wary of ‘cheap stocks’ in declining industries, TSCO.L (http://www.valuetrader.net/Valuation.aspx?ID=54&Code=TSCO.L) is a good example. Trading at GBP 1.40 with a crazy 10% dividend yield, yet in a situation where declining earnings and market share make it questionable whether the retail giant can sustain itself long term.

I think the best approach is to look for value but do your research as well and try and find the reason why a stock is trading relatively cheaply, and to use this information to determine if the market has overreacted (for example, to recent bad news or other short-term market shock). If the fundamentals and long term prospects are good you have a winner.

I remember reading someone’s tweet (sorry, can’t remember who it was..) saying something like netnets and other Graham-like stocks work when the times are bad. When the times are good (defined as times when stocks have soared up as they have now for several years) the netnets or “super cheap” -looking stocks you have on the market tend to be those that just look cheap, but aren’t really. I don’t have data to back that up, but it sounds reasonable to me. When we’ve gone up as we have now, the cheap stuff you find is much more likely cheap for a reason, compared to the times when we’ve gone downhill for a while.

This isn’t anything new, but I think a good reminder that it helps to have the ability to move to different types and classes of assets depending on what kind of times we’re living. Netnets and other cheap stuff one finds in screeners may not be the best way for now.

very good post! The “potential underperformance for longer stretches of time” point you made is one of the most important and difficult issues for me. It very often comes down to aspects of psychology that makes me wondering if a so far rock solid investment thesis is still good. Patience (and slow investing ;)) is certainly key in the long run. I cannot agree more. Thanks for the reminder!

With regard to deep value I have doubts that this is still working today as it did in Grahams times with information now broadly available. Like you, I don’t see any advantage on that one without a catalyst.

You once wrote one (or even more) great articles about how to increase your circle of competence by carefully testing new areas.
For me this article sound contradictory – you seem to cut areas out of looking that may be worth another try.

I know more (and less) succesful investors with deep value, more (and less) succesful investors with higher priced value, the same for growth investing or investing in turn-arounds, and even for chart investors and traders.
There are several strategies, and there are good (and bad) times, branches and regions for the different investing strategies.
If there were only one “golden” way to success it would be way too crowded already.

I feel very comfortable with many ideas you pick, I really like your investment style. But I also try to exercise with one share in the account per time of the deep value/net-net section (actually Balda), or at least one share of the turn around section (BlackBerry, Saga furs), not at least to slowly increase my circle of ompetence.
But I agree with you: Learning about “red flags”, about signs how to avoid loosers, is a very important part of this Circle. Hence analyzing red flags of loosers may be as instructional as anaylizing secrets of winners.

1) Circle of competence: For me this refers to new sectors/countries/business models. I actually have looked at different situations (Turnaround/distressed) as well, You might recall from the blog for instance the Praktiker bond or the IVG bond. But at least for me I found it very difficult to invest and be succesful in those cases. I do think that it is really hard to make consistently money in distressed/highly leveraged/questionable companies. The occasional success yes,but then also many losers…..

Clearly every investor has to try out what works for him,but I decided to make different bets.

2) I only invest if the company has provenin the past that doing things differently results in superior returns. The companies I own in this category have all proven over the years that they do better as their normal peers. It is clearly no guarantee for profits. TGS for instance is now negative since I bought it,but it is doing significantly better than any of its peers which actually enforces the case long term.

The typical “story stock” most often has a bad or no history and claims that the future will be much better because they are riding some kind of trend. Those stories are almost always only promises for the future, rarely based on superior past results.

Thanks MMI, now I agree with you
Only one last point: Story stocks are quite often bad copycats of some quite succesful searching ideas. The tracks have gone too full by the many followers, so people could sell them everything.
I would not wonder if it one days happens with your idea of “doing things different” as well. But I have few doubts that in this moment you are already looking for new, less beaten tracks and ideas.

@ tonyfonda: Of course Saga Furs is a bet with risks, just as all turn arounds. I wrote my opinion in a small German share forum so I hope you (or at least google translate) can read German good enough: http://www.stw-boerse.de/forum/messages/1719/3685.html
Glad to read your comments, here or at stw-boerse.de

Great Post. And definitely something I have been realizing myself across the deep value portion of my portfolio. “Great companies at fair prices”, right? 😉
Btw, do you happen to have an opinion on Rocket Internet? As you mention Amazon, and how Value Investors would’ve missed it, it would be great to hear your take here.

I guess to profit from this deep value stuff you have to invest into a very large number of “cheap” stocks, so that statistics work in your favour. You cannot run a relatively concentrated portfolio with a deep value strategy, because if one blows up, your performance is gone. And it is nearly impossible to do “deep analysis” for a large number of stocks (unless you have a large research team at hand). As far as I know, guys like Walter Schloss and Ben Graham always ran ‘large number portfolios’.

There are some workers whose behaviour is so bad that they will cause real harm to an organisation. They are so awful that colleagues and customers will leave the organisation to avoid working with them, and their behaviour can even be infectious.
Harvard Business School research terms these employees “toxic” workers. Researchers found that such staff can have more of an impact on the performance of an organisation than superstar workers. Managers would be better off spending their resources on avoiding hiring these problem staff, over solely seeking out top performers, the study’s authors say.

beause I think that (with a high probability) expensive Swiss Watches are not in a structural decline but rather a cyclical one. But it is a good point, structural vs. cyclical is mostly not crystal clear…..

yes, that would be another warning sign, especially when the selling happens across a large group of insiders. Individiuals might have other reasons (divorce, retirement). Especially when insider selling happens at a company where some of the other factory apply as well, one really has to be very careful.